CFA Institute Journal Review November 2015 Volume 45 Issue 11
Value versus Growth Investing: Why Do Different Investors Have Different Styles? (Digest Summary)
Journal of Financial Economics
Differences in individual investor behavior stem from genetic predispositions and environmental factors. Several determinants play a critical role in why some individuals become value-oriented investors and others become growth-oriented investors.
With so much research being done on value versus growth investing, surprisingly little effort has been made to explain the factors that influence individual investors’ decision making. The authors show that an investor’s investment style (i.e., value versus growth) can be derived from two sources: a genetic or biological predisposition and environmental factors. The authors reference several previous studies and provide their own analysis to contribute a new perspective about why investors gravitate toward value or growth investments.
How Is This Research Useful to Practitioners?
Several factors explain an individual investor’s investment preference for either value- or growth-oriented portfolios. The authors estimate that genetic differences account for approximately 26% of the orientation when measured by P/Es and 27% when measured by Morningstar’s Value-Growth Score. This result is consistent with the findings of previous researchers, who have shown that approximately 30% of the cross-sectional variation in financial risk preferences is explained by genetic predispositions. In addition to biological considerations, the analysis demonstrates that particular individual life experiences affect investment styles.
Experiences in early adulthood can have profound implications on preferences later in life, according to social psychology and neuroscience. A person’s core beliefs seem to crystallize during this early period of great neuroplasticity, and those beliefs remain consistent throughout a person’s life. Researchers have shown that neural pathways and synapses can dramatically change during these formative years as a result of a person’s environment, behavior, emotions, and even injury.
Significant macroeconomic events that investors experience can also have long-term and persistent effects on that individual’s behavior much later in life. The authors find that individual investors who experienced difficult economic conditions and grew up in lower-income homes develop a more value-oriented investment style later in life. For example, people who grew up during the Great Depression subsequently favor value-oriented, or “cheaper,” portfolios. These investors hold portfolios with an average P/E that is 11% lower at the median. The authors’ research also reveals that the timing of an individual’s entrance into the labor market can affect that individual’s future investment decisions. If an investor enters the labor market during a severe recession, he favors more value-oriented portfolios in the future.
Conversely—and consistent with previous studies—the authors find that investors with more education, with more disposable income, and whose income is correlated with GDP favor growth investments. Additionally, investors who exhibit more behavioral biases, such as the overconfidence bias, opt for growth investments. Individuals who exhibit more behavioral biases are found to have portfolios with a 10% higher P/E at the median.
This research contributes to and supports the growing body of evidence regarding behavioral finance, which demonstrates that life experiences, behavioral biases, and genetics have a dramatic impact on investors’ behavior.
How Did the Authors Conduct This Research?
The data are from the Swedish Twin Registry and include information on 10,490 identical and 24,486 fraternal twins who are investors in the stock market. Prior to 2007, all Swedish financial institutions were required to report detailed individual information about portfolio holdings. Using the entire period for which the data are available, the authors match the individuals from the dataset with the detailed portfolio data from 1999 to 2007. From these data, the authors find that identical twins’ investment styles are significantly more correlated than those of fraternal twins, but even identical twins show sizable differences in investment styles. By identifying genetic and environmental factors, the authors determine that between 26% and 40% of the variation is genetic, and the remaining portion is explained by common and individual environmental factors.
Each investor is categorized along a continuum of value versus growth. For individual stocks, the authors use the P/E and the price-to-book ratio. For mutual funds, the Morningstar Value-Growth Score and the name-based value/growth measure are used.
The results might help explain the value premium better, which could reflect both risk-based compensation and mispricing because of investors’ behavioral biases. This research, coupled with the growing body of literature on cognitive biases, could be extremely helpful to investment professionals who work directly with clients. By digging a bit deeper and learning more about ourselves and our clients, we as investment professionals can educate our clients from a place of understanding our different perspectives, which should provide a better overall client experience.